The Next Banking Crisis

Last June, Thomas Cox, a legal-services lawyer representing a Maine homeowner named Nicolle Bradbury, took an extended deposition from a clerk for the mortgage giant GMAC, which was trying to foreclose on Bradbury's house. GMAC, once the financing arm of General Motors, received a $17.3 billion bailout in 2009 and became 56 percent government -- owned. The clerk, Jeffrey Stephan, admitted that he signed over 400 affidavits a day attesting to documents that were supposed to be in files but were not. The case brought to light a widespread industry practice known as robo-signing.

Cox, summarizing the deposition to Judge Keith Powers, declared, "When Stephan says in an affidavit that he has personal knowledge of the facts stated in his affidavits, he doesn't. When he says that he has custody and control of the loan documents, he doesn't. When he says that he is attaching 'a true and accurate' copy of a note or a mortgage, he has no idea if that is so."

When the judge ruled against the bank's request for summary judgment in September, all hell broke loose. Judge Powers reprimanded GMAC, noting that the lender had been warned to cease such practices in a Florida case four years earlier. This prompted GMAC to temporarily suspend foreclosures in the entire country. JPMorgan Chase followed suit, suspending foreclosures in the 23 states where foreclosures must be approved by a judge.

The banking industry contends that these are isolated problems, but evidence is accumulating that such lapses are pervasive. Robo-signing and other careless practices occurred not just on the back end, when a bank tried to foreclose, but on the front end, in the creation and packaging of the original mortgages.

Evidence coming to light suggests that as subprime loan -- origination mills went into overdrive during the boom, they got very sloppy. As loans were turned into securities, many of the trusts that supposedly hold the documents have neither the actual promissory notes nor the liens that give the lender the right to foreclose. The problem was compounded when lenders created an electronic database called the Mortgage Electronic Registration System, or MERS. Often, physical notes were eliminated in favor of electronic ones; however, the law in most states requires that the original note be endorsed -- in "wet ink" -- to each new owner at every step of securitization.

Katherine Porter, a law professor at the University of Iowa and an expert in mortgage servicing, recently testified to the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) that according to lawyers for both home-owners and banks, "a very large number (perhaps virtually all) securitized loans made in the boom period in the mid-2000s contain serious paperwork flaws, did not meet underwriting or other requirements of the trust, and have not been serviced properly as to default and foreclosure."

So, this legal morass doesn't just gum up foreclosures; it calls into question whether several trillion dollars worth of mortgage-backed securities are worth anything close to their face value. Confronted with this incipient crisis, the Treasury Department is in a dither, torn between the need to take aggressive steps to prevent the mess from accelerating into a full-blown banking panic and the desire to reassure money markets that all is well.

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On Oct. 18, the Federal Reserve Bank of New York joined two large investment companies, Pimco and BlackRock, in sending a remarkable letter to Bank of America. The letter demanded that the bank make good on some $47 billion worth of securities with documentation problems similar to those revealed in the Maine case. Some of these securities had been purchased by the New York Fed as part of its bank-bailout program.

When a bank turns mortgages into securities, investors are given a "put back," or a right to demand that the bank buy the securities back if they turn out to be legally flawed. The Fed has told the Congressional Oversight Panel that, on average, Bank of America's mortgage securities, totaling over $2 trillion, are worth only about 50 cents on the dollar. If even a fraction of these have to be bought back by Bank of America, whose equity is about $230 billion, the bank is bust.

While the New York Fed was worrying about getting its money back, the Treasury was telling Congress that nothing was seriously amiss. Testifying before the oversight panel on Oct. 27, Phyllis Caldwell, the Treasury official in charge of foreclosure prevention, said, "We're very closely monitoring any litigation risk to see if there is any systemic threat, but at this point, there's no indication that there is."

Obviously, the New York Fed and the Treasury can't both be right. At the same hearing, the panel's new chair, Sen. Ted Kaufman of Delaware, who succeeded Elizabeth Warren, warned, "If investors lose confidence in the ability of banks to document their ownership of mortgages, the financial industry could suffer staggering losses."

While the Treasury and the banking industry are insisting that the documentation mess can be contained, the oversight panel's most recent report, released Nov. 16, comes very close to declaring that the foreclosure stalemate will trigger the next banking crisis. "In essence," warns the panel, "banks may be unable to prove that they own the mortgage loans they claim to own."

Referring to the body created by the Dodd-Frank Act to end "too big to fail," the panel's deputy chair, Damon Silvers, says, "For the new systemic-risk council to do its job, it has to be able to identify systemic risks and act on them. But because of worries about market confidence, systemic risks have become the phenomenon that dares not speak its name."

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There is, however, a potential silver lining. The mortgage documentation fiasco could force Congress and the administration to get serious about mortgage relief for the more than 7 million families still at risk of losing their home -- and to finally demand an honest accounting at the big banks. Most homeowners now in default did not have subprime loans and are merely victims of the general downdraft in housing prices triggered by the subprime collapse and the recession that followed -- now intensified by the foreclosure epidemic. Since homes are still the most important consumer financial asset in the economy, the deepening housing depression is the biggest single drag on economic recovery.

A lot of loans that were perfectly sound when they were made are now "underwater" -- the house is worth less than the loan. But the administration's Home Affordable Modification Program (HAMP), a loan-modification scheme voluntary to bankers, has delivered fairly shallow relief to only about 460,000 at-risk home-owners, half of whom are expected to go back into default.

The wave of foreclosures increases the number of empty houses, intensifying the collapse of housing values, with ripple effects far beyond subprime. To stem that tide, the administration would have to get much more serious about mortgage relief. That option seemed off the table -- until the documentation disaster struck.

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What now? As more homeowners fight foreclosures in court and more bank lapses come to light, judges are increasingly likely to require accurate documentation before they approve foreclosures. But since many of the original lenders have gone bankrupt, reconstructing valid loan documents may be literally impossible, except by fraudulent back-dating. The administration has rejected calls for a moratorium on foreclosures, but we may get an inconclusive, partial moratorium, one case at a time.

After a few more months of slow bleed, with more such letters not just from the Fed but from the pension funds and mutual funds that hold trillions of dollars of bonds backed by mortgages, the financial industry will be increasing desperate. In September, the industry tried sneaking a bill through Congress requiring questionable mortgage affidavits to be recognized in courts across state lines. But that bill was vetoed by President Barack Obama on Oct. 8.

The Republicans are torn between the desire to bash banks and to quietly aid them. On Nov. 17, Republicans in the lame duck House tried and failed to override Obama's veto of the affidavit bill. Republicans were elected as foes of government, but it is all too clear that only government can resolve this legal tangle. The question is how.

One remedy, proposed by professor Adam Levitin of the Georgetown Law Center, would create a new chapter of the bankruptcy code and allow a home-owner to come before a bankruptcy judge and get the mortgage reduced to the present value of the home. The process would also clear the title.

Another proposal, by professor Howell Jackson of Harvard Law School, would use government's power of eminent domain to take securitized mortgages, compensate the holder at the securities' (much reduced) fair market value, and use the savings to turn the paper back into whole mortgages with steep reductions in interest and principal. This would also allow millions of people to keep their home and help stem the broad decline in housing values.

The Treasury, under its new systemic-risk authority, could also take a much tougher line with banks on refinancings. And a task force of state attorneys general is increasing the pressure on banks to come clean.

One way or another, this crisis is coming to a head. Accepting a wrecked land-title system that randomly blocks some foreclosures and allows homeowners to stay put as squatters is no solution. The oversight panel estimates it will cost upwards of half a trillion dollars to do enough mortgage refinancing to allow at-risk homeowners to legally keep their home. Such a move may drive some banks into negotiated bankruptcies, in which their shareholders and bondholders eat a lot of the mortgage losses and then the successor bank resumes operations with a clean balance sheet. The alternatives are clear: Slow economic stagnation, prolonged legal limbo for homeowners and banks, another financial panic -- or a responsible solution to the mortgage mess that requires an honest accounting of bank balance sheets. That accounting is long overdue.